1 Monetary Policy How Monetary Policy Works in the Models Price level Real output AD 0 P0P0 AD 1 P1P1 Y0Y0 Y1Y1 SAS Monetary policy affects both real output and the price level AD 2 Expansionary monetary policy shifts the AD curve to the right Contractionary monetary policy shifts the AD curve to the left Y2Y2 P2P2

1 Monetary Policy How Monetary Policy Works in the Models Price level Real output P0P0 P1P1 YPYP LAS SAS 1 SAS 0 If the economy is at or above potential, expansionary monetary policy will cause input costs to rise The only long-run effect of expansionary monetary policy when the economy is above potential is to increase the price level Rising input costs will eventually shift the SAS curve up so that real output remains unchanged AD 0 AD 1

1 Monetary Policy How Monetary Policy Works in the Models  Expansionary monetary policy is a policy that increases the money supply and decreases the interest rate and it tends to increase both investment and output  Contractionary monetary policy is a policy that decreases the money supply and increases the interest rate, and it tends to decrease both investment and output M i IYM i IY

1 Monetary Policy Structure of the Fed Board of Governors 7 members appointed by the president and confirmed by the senate FINANCIAL SECTOR GOVERNMENT Regional Reserve Banks and Branches 12 regional Federal Reserve banks and 25 branches Oversees Federal Open Market Committee (FOMC) Board of Governors plus 5 Federal Reserve bank presidents Provides Services Open Market Operations

1 Monetary Policy The Complex Nature of Monetary Policy Fed toolsOperating targetIntermediate targetsUltimate targets Open market operations, Discount rate, and Reserve requirement Fed funds rate Consumer confidence Stock prices Interest rate spreads Housing starts Stable prices Sustainable growth Acceptable employment Moderate i rates While the Fed focuses on the Fed funds rate as its operating target, it also has its eye on its ultimate targets: stable prices, acceptable employment, sustainable growth, and moderate long-term interest rates